DIVISIONAL PERFORMANCE MEASURES (MODERN

PERFORMANCE MEASURES)
AND TRANSFER PRICING
 Overview

Responsibility accounting
Investment centre performance appraisal methods
 Return on investment (ROI)
 Residual income (RI)
 Economic value added (EVA)
Transfer pricing
 Aims
 Approaches
 Market based
 Cost based
 Opportunity cost
 Introduction….
A feature of modern business management is the practice of splitting a business into semi-
autonomous units with devolved authority and responsibility. Such units could be described as
'divisions', subsidiaries or strategic business units (SBUs) but the principles of operations are the
same.
 
Divisional structures may result in the following problems:
Co-ordination - how to co-ordinate different divisions to achieve overall corporate objectives.

Goal congruence- managers will be motivated to improve the performance of their division,

possibly at the expense of the larger organisation.

Head office costs - whether/how head office costs should be reapportioned.

Transfer prices - how transfer prices should be set as these effectively move profit from one

division to another.
Controllability - divisional managers should only be held accountable for those factors that

they can control. The performance of a division's manager must be appraised separately to the
performance of the division. It may be difficult to determine exactly what is and what is not
controllable.
Inter-dependence of divisions - the performance of one division may depend to some extent on

others, making it difficult to measure performance levels.

 
 Introduction

 Generally a company with several divisions will be a decentralised

organisation. In such organisations divisional managers tend be
responsible for making their own decisions concerning the operation of
their division.

 Advantages of decentralisation include:

 Decisions taken more quickly
 Increase motivation of management
 Increase quality of decisions due to local knowledge
 Reduce head office bureaucracy
 Provide better training for all levels of management
 Disadvantages of decentralisation
 Potential for dysfunctional decision-making
 Duplication amongst divisions leading to greater cost
 Senior management loss of control
 Appropriate performance evaluation methods are therefore needed.
 Introduction

Conditions for a good performance measure

A good performance measure should:
 Provide incentive to the divisional manager to make decisions which
are in the best interests of the overall company (goal congruence)
 Only include factors for which the manager (division) can be held
accountable
 Recognise the long-term objectives as well as short-term objectives
of the organisation.
Numerical measures of divisional performance
Performance measures…..
 Responsibility accounting

Responsibility centre Manager’s area of Typical financial

responsibility performance measure
Cost centre Decisions over costs Standard costing
variances
Revenue centre Revenues only Revenues
Profit centre Decisions over costs and Controllable profit
revenues
Investment centre Decisions over costs, Return on investment,
revenues, and assets residual income and EVA
 Investment centres

Within an investment centre, managers also have

responsibility over investments and assets.
To measure their performance purely on say profit
would be only focussing on part of the picture.
To overcome this, we use methods which measure
the assets and the profit they generate.
 Return on investment (ROI)

What is ROI?
ROI = PBIT/Capital Employed x 100
If ROI > Cost of capital (required return), then
accept the project.
ROI enables performance in different divisions to be
compared.
Similarly, new investments can also be appraised
using ROI.
 ROI

Problems with ROI

 Dysfunctional behaviour – only projects which increase ROI
will be accepted, this could be at the expense of growth in
corporate profits.
 The ratio will be distorted by the age of the assets
 Profit can be manipulated
Advantages
 Widely used and accepted
 As a relative measure it enables comparisons to be made with
divisions or companies of different sizes.
 Alternative

ROI is the most frequently used criterion for divisional performance

measurement.
 Example 1

Suppose that a company has two investment centers A and B, which show
results for the year as follows.
 
   
A  
B
 
     

 
Profit  
60,000  
30,000
 
Capital employed  
400,000  
120,000
 
ROI  
15%  
25%

Investment center A has made double the profits of investment center

B, and in terms of profits alone has therefore been more 'successful'.
However, B has achieved its profits with a much lower capital
investment, and so has earned a much higher ROI. This suggests that B
has been a more successful investment than A.
 Test Your Understanding 1

Managers within MV plc are appraised on the ROI of their division. The
company's cost of capital is 15%. Jon, a divisional manager, has the following
results:

Profit 30,000
Investment 100,000

Within his division, the purchase of a new piece of equipment has been
proposed. This equipment would cost 20,000, would yield an extra 4,000 of
profit and would have many other non-financial and environmental benefits to
the division and the company as a whole.
 
Required:
Will Jon invest in the new equipment? Is this the correct decision for the
company?
 Residual income

Residual income (RI) is the income a division produces

in excess of the minimum required rate of return.
.
PBIT(or controllable profit) X
less: Imputed interest
(= Capital employed × Cost of Capital) (X)
Residual income X

The result is an absolute figure.

 Example 2

Division A produces 200,000 income on an investment of

1,000,000, an ROI of 20 percent, while Division B earns 1,500,000
on an investment of 10,000,000, an ROI of 15 percent. Cost of
capital is expected to be 10%. Calculate RI

  Division A Division B
Investment 1,000,000 10,000,000
Division income 200,000 1,500,000

Investment * Cost of capital -100,000 -1,000,000

Residual income 100,000 500,000

 Test Your Understanding 2

Division A produces 4,400,000 income on an investment of

11,000,000, ROI of 40 percent, while Division B earns
7,000,000 on an investment of 10,000,000, ROI of 70
percent. Given 18% cost of capital. Calculate RI for the two
projects.
 Test Your Understanding 3

Black Dog Inc has the following financial performance:

Black Dog wishes to evaluate on the basis of residual

income whether to accept a new possible investment costing
10,000 which would earn profit of 2,000 pa.
 Evaluation of RI as a performance measure
Advantages of residual income
 Avoids dysfunctional behaviour-there is a greater probability
that managers will be encouraged, when acting in their own
best interests, also to act in the best interests of the company
 Different costs of capital can be used to reflect risk-More
flexible
ROI vs. RI
In practice, however, ROI is used more frequently
than RI, for the following reasons:
 Dysfunctional behaviour is not material
 ROI is consistent with corporate assessment (ROCE)
 Percentages are more easily understood
 RI requires a cost of capital
 Disadvantages of RI
Absolute measure – it means that it is difficult to
compare the performance of a division with that of other
divisions or companies of a different size. To overcome
this deficiency, targeted or budgeted levels of RI should
be set for each division that are consistent with asset
size and the market conditions of the divisions.

Residual income is an accounting-based measure, and

suffers from the same problem as ROI in defining
capital employed and profit.
 ROI VERSUS ROI
RI is favoured for reasons of goal congruence and
managerial effort. Under ROI the basic objective is to
maximize the rate of return percentage. Thus, managers of
highly profitable divisions may be reluctant to invest in the
projects with lower ROI than the current rate because their
average ROI would be reduced.
 
On the other hand, under RI the manager would be inclined
to invest in the projects earning more than the desired rate
of return, i.e., the risk-adjusted cost of capital. Despite its
known disadvantages, most managers agree that the rate of
return on invest is the ultimate test of profitability.
 Test Your Understanding 4

Division Z has the following financial performance:

Required:
Would the division wish to accept a new possible investment costing 10,000
which would earn profit 2,000 pa if the evaluation was on the basis of?
(a) ROI
(b) RI?
Is the division's decision in the best interests of the company?
 Economic Value Added

Economic value added (EVA) is a performance metric that is

very similar in approach to residual but superior, measure to RI.

EVA = Net operating profit after tax (NOPAT) – (WACC x

book value of capital employed).

The principle behind it is that a business is only really

creating value if its profit is in excess of the required
minimum rate of return that shareholders and debt holders
could get by investing in other securities of comparable risk.
 Economic value added (EVA)

It is directly linked to the creation of shareholder

wealth and is calculated as follows:
NOPAT X
less: Economic value of
capital employed x WACC (X)
EVA (Capital charge) X

Note:
WACC = weighted average cost of capital

Advantages
Consistent with NPV so should not
result in dysfunctional behaviour.
The cost of financing a division is
brought home to the division’s
manager.
Is based on cash flows and hence less
distorted by the accounting policies
chosen.
EVA
Disadvantages
There are many assumptions made
when calculating the WACC
It ignores items that don’t appear on the
balance sheet such as brands and
inherent goodwill.
Costly to maintain and training may be
required.
 EVA

The notional capital charges use different bases for net assets. The
replacement cost of net assets is usually used in the calculation of EVA.

Capital employed at the beginning of the period should be used instead of

end of the period.

The profit figures are calculated differently. EVA is based on an

economic profit which is derived by making a series of adjustments to
the accounting profit.

There are also differences in the way that NOPAT is calculated

compared with the profit figure that is used for RI.
 NOPAT Calculations
Costs which would normally be treated as expenses, but
which are considered within an EVA calculation as
investments building for the future, are added back to
NOPAT to derive a figure for 'economic profit'.

These costs are included instead as assets in the figure for

net assets employed, i.e. as investments for the future.
Costs treated in this way include items such as goodwill,
research and development expenditure and
advertising costs and marketing costs.
 NOPAT …..

Adjustments are sometimes made to the depreciation charge,

whereby accounting depreciation is added back to the profit figures,
and economic depreciation is subtracted instead to arrive at
NOPAT. Economic depreciation is a charge for the fall in asset value
due to wear and tear or obsolescence.
 
Any lease charges are excluded from NOPAT and added in as a part
of capital employed.
 
Another point to note about the calculation of NOPAT, which is the
same as the calculation of the profit figure for RI, is that interest is
excluded from NOPAT because interest costs are taken into account
in the capital charge.
 
 Major Adjustments
Add back to profits:
1.Expenditure on building for the future (e.g. research expenditure, marketing expenditure and
staff training):
2.Non-cash expenses
3.Provisions for bad and doubtful debts
4.Goodwill written off
5.Depreciation: add back book depreciation and deduct economic depreciation. If economic
depreciation is not given, assume it is the same as book depreciation and that there is no net
adjustment.
6.Interest on debt capital-Add back to net profit after adjusting for any tax relief.
7.Treat the debt as part of capital employed

Adjustment to statement of financial position

1.Non-capitalized leases
2.Research etc.. now capitalized
3.Goodwill written off
4.Provisions
NOPAT Cont….
 Example

An investment center has reported operating profits of 21 million.

This was after charging 4 million for the development and launch
costs of a new product that is expected to generate profits for four
years. Taxation is paid at the rate of 25 per cent of the operating
profit.
 
The company has a risk adjusted weighted average cost of capital
of 12 per cent per annum and is paying interest at 9 per cent per
annum on a substantial long term loan.
 
The investment centre's non-current asset value is 50 million and
the net current assets have a value of 22 million. The replacement
cost of the non-current assets is estimated to be 64 million.
 NOPAT Adjustments
Summary
Intangibles-Research & development costs, advertising costs, marketing costs
Added back to the net profit and to the BV added back to the capital employed
(Cost-Expired cost)-Amortized costs
Good will written off- Added back to the net profit and CE
Depreciation-Accounting dep should be replace with economic dep.
Provision for bad debts-Added back to the net profit and to the CE
Leased assets-Added back to the CE
Interest on debt-Added back to the net profit then debt should treated as part of
CE
Non-cash expenses should be added back to the net profit and also to the capital
employed
NB: EVA-Replacement costs of NCA
CE at the start of the year (consider closing balance from the previous
period)
 Solution

Calculation of NOPAT m
Operating profit 21
Add back development costs 4
Less: one year’s amortization of development cost (4m/4) (1)
  24
Taxation at 25% (6)
NOPAT 18

Calculation of economic value of net assets m

Replacement cost of net assets (22m + 64m) 86
Economic value of net assets = development cost 3
  89
 Solution

Calculation of EVA
The capital charge is based on the WACC, which takes into account of the cost of
share capital as well as the cost of loan capital. Therefore the correct interest
rate is 12%.

  M

NOPAT 18.00

Capital charge (12% x 89m)

   
10.68

EVA 7.32
 (M)
Operating profit 21
Add: Development cost 4
25
Less: Development cost (Amortised) -1
24
Less: Tax (25%) 6
NOPAT 18

Capital employed
Replacement cost of NCA 64
Current asset 22
Total assets 86
Add: Net development cost 3
Total capital employed 89

EVA=NOPAT-Capital employed*WACC= EVA=18-(12%*89)=7.32

 Example 2

2015 2014
Profit before interest 2,000 1,600
Interest (400) (400)
Profit after interest 1,600 1,200
Tax @25% (400) (300)
Profit after tax 1,200 900
Non-cash expenses 100 120
Year end capital employed 10,000 8,000
WACC 15% 16%
Calculate EVA for 2015
Solution
 Advantages of EVA
Real wealth for shareholders. Maximisation of EVA will create real wealth for the
shareholders.
 
Less distortion by accounting policies. The adjustments within the calculation of
EVA mean that the measure is based on figures that are closer to cash flows than
accounting profits.
 
An absolute value. The EVA measure is an absolute value, which is easily
understood by non-financial managers.
 
Treatment of certain costs as investments thereby encouraging expenditure. If
management are assessed using performance measures based on traditional
accounting policies they may be unwilling to invest in areas such as advertising
and development for the future because such costs will immediately reduce the
current year's accounting profit. EVA recognises such costs as investments for
the future and therefore they do not immediately reduce the EVA in the year of
expenditure.
 
 Disadvantages of EVA

Focus on short-term performance. It is still a relatively short-term measure,

which can encourage managers to focus on short-term performance.
 
Dependency on historical data. EVA is based on historical accounts, which may
be of limited use as a guide to the future. In practice, the influences of accounting
policies on the starting profit figure may not be completely negated by the
adjustments made to it in the EVA model.
 
Number of adjustments needed to measure EVA. Making the necessary
adjustments can be problematic as sometimes a large number of adjustments are
required.
 
Comparison of like with like. Investment centres, which are larger in size, may
have larger EVA figures for this reason. Allowance for relative size must be made
when comparing the relative performance of investment centres.
 
 Assignment 1

Division X is currently generating a ROI of 12%. It is considering a new project.

This requires an investment of 1.4 million and is expected to yield net cash
inflows of 460,000 per annum for the next four years. None of the initial
investment will be recoverable at the end of the project. The company has a cost
of capital of 8%. Annual accounting profits are to be assumed to equal annual net
cash inflows less depreciation, and tax is to be ignored.
 
Required:
(a)Calculate and comment on the NPV of the project.
(b)Calculate and comment on the ROI and RI of the project.
(c)Calculate and comment on the ROI and RI of the project using annuity
depreciation.
(d)Calculate and comment on the ROI and RI of the project at the project IRR of
12%.
 Practice Question
Extracts from the accounts of V Co are as follows:
Income Statements: 2014 (M) 2013 (M)
Revenue 608 520
Pre-tax accounting profit 134 108
Taxation (46) (37)
Profit after tax 88 71
Dividends (29) (24)
Retained earnings 59 47

Statement of financial position 2014 (M) 2013 (M)

Non-current assets 250 192
Net current assets 256 208
506 400
Financed by: Shareholders’ funds 380 312
Medium and long-term bank loans 126 88
506 400
 Additional Information
Note: After deduction of the economic depreciation of the company’s non-current assets. This is
also the depreciation used for tax purposes. Other information is as follows:
1. Capital employed at the end of 2012 amounted to 350m.
2. Value Co had non-capitalised leases valued at 16m in each of the years 2012 to 2014. The
leases are not subject to amortisation.
3. Value Co’s pre-tax cost of debt was estimated to be 9% in 2013 and 10% in 2014.
4. Value Co’s cost of equity was estimated to be 15% in 2013 and 17% in 2014.
5. The target capital structure is 70% equity and 30% debt.
6. The rate of taxation is 30% in both 2013 and 2014.
7. Economic depreciation amounted to 64m in 2013 and 72m in 2014. These amounts were
equal to the depreciation used for tax purposes and the depreciation charged in the income
statements.
8. Interest payable amounted to 6m in 2013 and 8m in 2014.
9. Other non-cash expenses amounted to 20m in 2013 and 15m in 2014.
10. Research and development expenditure on a new project started in 2013 and written off was
10 million in 2013 and 11 million in 2014
Calculate the Economic Value Added in each of 2014 and 2013
 Solution

Divisional Performance Measurement, Economic Valu

e Added - YouTube
 Solution
2014 2013
PAT 88 71
Add: Interest 5.6 4.2
Non-Cash expense 15 20
Research & developm 11 10
NOPAT 119.6 105.2

Capital employed
2014 2013
Balance B/f 400 350
Add: Non-cash expense 20 0
Research & developm 10 0
Lease 16 16
446 366

WACC 14% 12%

EVA 57.16 59.85
TRANSFER PRICING
 TRANSFER PRICING
Within a decentralised organisation there may be a division which makes
units that are then transferred to another division.

COMPANY XY

SELLING DIVISION X BUYING DIVISION Y

Transfer price
1. Makes and sells flour 1. Makes and sells bread
2. The company has 2 options, 2. It can buy flour from
Transfer price Division X or external supplier
sell to division Y or to external
customers

It will usually be necessary to charge the receiving division for the goods
that it has received in order for performance to be measured equitably.
 Transfer pricing

A transfer price is the price at which goods are transferred internally.

The transfer price is the price that one division charges another
division of the same company for goods or services supplied from
one to the other.

Transfer pricing is the process of determining the price at which

goods are transferred from one centre to another centre within the
same company.

It is an internal charge – the ‘sale’ of one division is the ‘purchase’

of the other.
 Transfer pricing

Ideally transfer prices should:

1.Be perceived as fair to both divisions and therefore good for

performance measurement and management

2.Provide profits for both divisions because profits are motivating

3.Promote goal congruence so that divisions volunteer to do what is

good for the group

4.Promote autonomy i.e minimise head office interference

It is vital that the transfer price is carefully selected to ensure all

parties act in the best interest of the company.
 Transfer pricing

The goals of transfer pricing system are:

Goal congruence-The prices should be set so that the divisional
management’s desire to maximize divisional earnings is consistent
with the objectives of the company as a whole.
 
Equitable performance measurement-The prices should enable
reliable assessments to be made of divisional performance. (Equal
allocation of profits).
 
Retain divisional autonomy-The prices should seek to maintain the
maximum divisional autonomy so that the benefits, of
decentralization (motivation, better decision making, initiative etc.)
are maintained. The profits of one division should not be dependent
on the actions of other divisions
Transfer pricing
 Example 1

Division A produces goods and transfers them to Division

B which packs and sells them to outside customers.
Division A has costs of 10 per unit, and Division B has
additional costs of 4 p.u. Division B sells the goods to
external customers at a price of 20 p.u.

Assuming a transfer price between the divisions of 12 p.u.,

calculate:
(a) the total profit p.u. made by the company overall
(b) the profit p.u. made by each division
 Solution
a)
Selling price 20
Costs (10+4) 14
Profit 6

b)
A B
Selling price 12 20
Transfer price 12
Cost (10) Costs 4 (16)
Profit 2 4
 Transfer pricing in practice

Market based approaches

 If an external market exists for transferred goods (and there is
unsatisfied demand externally), the transfer price can be set as the
external market price.

 The selling division will earn at least the same profit on internal sales
as external sales, the receiving division will pay a commercial price
and both divisions will have their profit measured in an equitable way.
The managers of both divisions will behave in a goal congruent way.

 If savings are made by selling internally then this may be reflected in

the transfer price, e.g. by offering a discount equivalent to saved
transport costs.
 Transfer pricing in practice

Cost based approaches

The idea behind these approaches are similar to those involved in
manufacturing accounts, that is to say the supplying division has its
costs of manufacturing refunded and is also given a profit margin to
encourage the transfer.

A very common way in practice of determining a transfer price is

for the company to have a policy that all goods are transferred at
the cost to the supplying division plus a fixed percentage. (Cost-
plus transfer pricing).
 Example

Division A has costs of 15 p.u., and transfer goods to Division B

which has additional costs of 5 p.u.. Division B sells externally at
30 p.u. The company has a policy of setting transfer prices at cost
+ 20%.

Calculate:
(a) the transfer price
(b) the profit made by the company overall
(c) the profit reported by each division separately
(d) determine the decisions that will be made by the managers and
comment on whether or not goal congruent decisions will be
made.
 Solution

a) Transfer price = 15*1.2=18 p.u

b) Selling price 30
Cost A 15
B 5 (20)
Profit 10

A B
Transfer price 18 Selling price 30
Cost 15 Transfer in 18
Profit 3 Costs 5 23
Profit 7
 Other practical approaches
Marginal cost: condemns selling divisions to making losses because
fixed costs are not covered. However, promotes goal congruent
decisions

Marginal cost plus lump sum: during the year marginal costs are
used (goal congruence). At the end of the an additional lump sum is
transferred between transferee and transferor to account for profits.

Dual prices: transferee transfers at a markup (so makes a profit);

transferee buys in at marginal cost (so can make correct decisions for
goal congruence).
“Sensible” transfer pricing to achieve goal congruence.

Utmost care should be taken to set the transfer price which is

sensible, decisions should be made that are not goal congruent.
Sensible transfer prices is set within a range rather than one specific
price.

Example 3
Division A has costs of 20 p.u., and transfer goods to Division B
which has additional costs of 8 p.u.. Division B sells externally at 30
p.u.

Determine a sensible range for the transfer price in order to

achieve goal congruence
 Solution

For A: Transfer price = 20

For B: Selling price 30
Less: Costs (8) = 22

Sensible Transfer price 20 and 22 per unit

 Example 4

Division A has costs of 15 p.u., and transfers goods to

Division B which has additional costs of 10 p.u.. Division
B sells externally at 35 p.u.

A can sell part-finished units externally for 20 p.u.. There

is limited demand externally from A, and A has unlimited
production capacity.

Determine a sensible range for the transfer price in

order to achieve goal congruence.
 Solution

For A: Transfer price > 15

For B: Selling price 33
Less: Costs (10) <25

Sensible Transfer price 15 and 25 per unit

 The ‘rule’ for sensible transfer pricing

Minimum transfer price = marginal cost to selling division

+ opportunity cost (lost contribution) to selling division

Maximum transfer price = external purchase price (buyer)

If external market for intermediate product, opportunity
cost = contribution foregone.

If no external market, the opportunity cost is likely to be

nil.
 Test Your Knowledge
Goods are transferred from Division S to Division R at cost + 10%.

Division S Variable costs 20.00

Fixed overhead 8.00
28.00
Standard profit @ 10% 2.80
Transfer price 30.80

Division R, the receiving division, can buy externally @ 26.

Required:
Discuss the likely outcome of setting the transfer price at 30.80.
Recommend a transfer price.
Answer
 Test Your Knowledge
A company has two divisions A and B. Division A manufactures a
component X that it can either sell outside or transfer it to division B.

The component has a variable cost of 24 to manufacture and sells for

40. A single component of X requires one direct labor to complete and
the division has a capacity of 25000 components per year.

Division B manufactures a product that requires a component slightly

different form X. It has a choice either buying it from outside or get it
from division B. Variable manufacturing costs would total 20 per unit
component of X.

What would be the starting point for the transfer price?

 Solution

Transfer price = variable cost/unit + lost contribution/unit

on outside sales= 20 + (40 – 24) = 36
 Test Your Knowledge

Division X has developed a new product that requires a custom made

fitting. Division Y has the experience to produce it.

Division X has approached Y for a quoted unit price based on the

production of 5000 fittings per year. Division Y has determined that
the fitting would require variable cost of 80 per unit.

However, on order to have time to produce the fitting, division Y

would have to reduce production of a different product A, by 350
units per year. Product A sells for 450 per unit and has variable costs
of 250 per unit.

What transfer price would be quoted by Y to X?

 Practice Question

A division has a product costing 5 which is transferred

within a group of companies. Calculate a transfer price for
the division for each of the following mutually exclusive
divisional targets:
 
1. A net profit margin of 10%
2. A mark-up on cost of 10%
3. A net assets turnover rate of 5 and an ROCE of 30%.
4. An output of 1,000,000 units, a capital employed of
2,000,000 and an ROCE of 20%
Solution
 Why have a transfer price?

The reason for having a transfer price is to be able to make each

division profit accountable.

If there is no transfer price between division A & B and goods were

transferred ‘free of charge’ between the division, then the overall
profit for the company would be unchanged.

However, Division A would only be reporting costs, and Division B

would be reporting an enormous profit.

The problem would be compounded if Division A was selling the

same product externally as well as transferring to Division B.
 Practice Question

A company operates two divisions, Able and Baker. Able

manufactures two products, X and Y.
Product X is sold to external customers for 42 per unit. The only
outlet for product Y is Baker.
Baker supplies an external market and can obtain its semi-
finished supplies (product Y) from either
Able or an external source. Baker currently has the opportunity
to purchase product Y from an external supplier for 38 per unit.
The capacity of division Able is measured in units of output,
irrespective of whether product X, Y or combination of both are
being manufactured.
The associated product costs are as follows.
 Practice question (cont’d)

X Y
Variable costs per unit 32 35
Fixed overheads per unit 5 5
Total unit costs 37 40
Required
Using the above information, provide advice on the determination
of an appropriate transfer price for the sale of product Y from
division Able to division Baker under the following conditions.
 When division Able has spare capacity and limited external demand for
product X
 When division Able is operating at full capacity with unsatisfied external
demand for product X
Answer
 Multinational Transfer Pricing

Globalisation, the rise of multinational companies, and the fact that more than
60% of world trade takes place within multinational organisations means that
international transfer pricing is very important.
When transfers occur between different countries, then there are additional
factors to take into account. These include the following:
1.Taxation in the different countries
2.Import tariffs
3.Exchange controls
4.Anti-dumping legislation, competitive pressures, repatriation of funds
In practice, most countries tax laws will include rules about transfer pricing.
Usually they encourage a transfer price at market value to ensure that both
countries receive a fair share of the profits. However, it is not always easy to
establish what is a fair market value. A transfer price at full cost is usually
acceptable to tax authorities, but transfer prices at variable cost are unlikely to be
acceptable.
 International transfer pricing

International transfer pricing refers to the determination of

prices to be charged between related persons and in
particular within a multinational enterprise for transactions
between various group members (sales of goods, the
provision of services, transfer and use of patents and know-
how granting of loans etc.)

As these prices are not negotiated in a free open market they

may deviate from prices agreed upon by non-associated
trading partners in comparable transactions under the same
circumstances.
 
 International transfer pricing

The above leads to a special interest on the part of tax

authorities in intra-group transactions and especially in
cross- border transactions. In many circumstances the tax
authorities would seek to adjust the prices adopted in these
transactions to arm’s length prices.

In such circumstances the tax authorities may seek to arrive

at the arm’s length price by using cost-based methods or
methods based on the price changed to the final customer
the ‘resale minus’ or resale price method or any other
which can produce an acceptable result.
 Example

Bright Shirt Company owns a manufacturing plant in Kenya

where its marginal tax rate is 60 per cent of net income.
These shirts are imported by Zambia where the marginal tax
rate is 75 per cent of net income. For simplicity assume that
there are no currency controls and that tax regulations
concerning the definition of taxable income are the same
between the two countries. During the current year, the
company incurred production costs equivalent to sh.2
million in Kenya. Costs incurred in Zambia aside from the
costs of the shirts amounted to an equivalent of sh.6 million.
Sales revenues in Zambia were sh. 24 million.
 Example
Similar goods imported by independent companies in Zambia would
have cost an equivalent of sh. 3 million. However, Bright Shirt
Company points out that because of its special control over its
operations in Kenya and the special approach it uses to manufacture
its goods, the appropriate transfer price is sh. 10 million.

Required:
1.What would Bright Shirt Company’s total tax liability in both
countries be if it used the sh. 3 million transfer price?
2.What would the liability be if it used the Sh. 10 million transfer
price?
 Solution

For 3 million transfer price, the tax liability will be;

Kenya (sh) Zambia (sh)

Sales revenues 3,000,000 24,000,000
Third party costs 2,000,000 6,000,000
Transferred goods costs 3,000,000
Total costs 2,000,000 9,000,000
Taxable income 1,000,000 15,000,000
Tax rate 60% 75%
Tax liability 600,000 11,250,000

Total tax liability = sh 11,850,000

 Solution

For the sh.10 million transfer price;

Kenya (sh) Zambia (sh)
Sales revenues 10,000,000 24,000,000
Third party costs 2,000,000 6,000,000
Transferred goods costs 10,000,000
Total costs 2,000,000 16,000,000
Taxable income 8,000,000 8,000,000
Tax rate 60% 75%
Tax liability 4,800,000 6,000,000

Total tax liability = sh 10,800,000

 Solution

The tax liability assuming a sh. 10 million transfer price is

about 9% less than the liability that would be incurred if the
transfer price was sh. 3 million.

International taxing authorities look closely at transfer prices

when examining the tax returns of companies engaged in
related party transactions which cross jurisdictional lines.

Companies must therefore have adequate support for the use

of the transfer price which they have chosen for such a
situation.
END OF LECTURE